I have written two articles discussing the recent events in the potash industry, and why I am long Potash Corp (POT). The first article describes how the Uralkali-Belaruskali fallout will impact the potash market in the short and long run. The second article describes why I believe that POT is not as exposed to the perceived macro headwinds as many believe. In this article, I will attempt to address my readers' questions and examine all the major fundamental reasons why I am long POT. If you read to the end, I will also offer my unique perspectives on the whole Uralkali spectacle.
Reason No. 1: Low Cost Producer Equals Forever Business
Potash is an abundant commodity with enough global deposits to last essentially forever. However, Potash deposits that are economically minable are concentrated in only a handful of countries and dominated by a handful of producers like Uralkali, Belaruskali, K+S, Potash Corp , Mosaic (MOS), Agrium (AGU), and Intrepid Potash (IPI).
In the short-run, potash prices will fluctuate widely. At the beginning of 2008, Potash prices started a meteoric climb from less than $200 a tonne to a high of $875 in Feb. 2009. These subsequently dropped dramatically to an April 2010 low of $310 level, before recovering in 2011-12, and relapsing again in 2013. For reference, prices in November 2011 were about $470 per tonne, but as of May 2013 were stable at ($393).
However, long-run prices are driven by the nearly inevitable global population growth to 9 billion by 2050 and the increasing affluence of emerging markets. (I said "nearly inevitable" because, who knows, a new virus or WW3 could wipe out the majority of humanity... in that case, I will have better things to worry about than my POT shares). Since the existing potash companies essentially picked the lowest hanging fruits (i.e. the economically minable deposits), generally speaking, they will always have a price advantage over any new entrants. And since the world is eating more and more, they will always have business.
Lowest-cost producers like POT will not have to worry about going out of business due to short-term price fluctuations because the lowest the price will go to, under normal circumstances, is the marginal producers' cost of production. Even at $300 per tonne potash, POT will have approximately 40-50% gross margins for its potash business.
Potash investors must have a strong stomach to withstand short-term fluctuations. However, buying a low-cost producer like POT will help you sleep better at night.
Reason No. 2: Uralkali's Impact on the Market and POT is Overestimated
For a detailed treatment, read my article here. Three key points to understand are as follows:
- Even if Uralkali produces at full capacity, it will only be an addition 1.5 to 2.5 million tonnes of potash annually. Uralkali's CEO predicts that 2014's global potash demand will grow by 10% to exceed 60 million tons.
- Only 23% of Potash's revenues and an estimated less than 23% of gross margins will be fully impacted by Uralkali's actions. Remember, POT dominates the North American market and is a diversified business.
- JPM estimates that the modeled price drop caused by Uralkali's actions will only lead to a small drop in POT's earnings per share from $2.50 to $2.35 EPS.
Reason No. 3: POT's 4.7% Dividend Yield Is Safe
At current price levels of around $30 per share, POT carries a very rich dividend yield of 4.7%. Many people are worried that the change in the potash landscape will force POT to slash its dividends, which will lead to a major sell-off of POT shares. However, these people are not considering a fundamental change within POT itself: the conclusion of its CapEx program.
According to an 8/7/2013 interview with POT's CEO, Bill Doyle (that is "Good Ol' Bill Doyle" to you), POT is 90% done with its CapEx program to expand its potash capacity to a whopping 17.1 tonnes (the second-largest company by capacity is Uralkali at 13 million tonnes).
POT's capacity expansion has been a major drag on free cash flow in recent years, so a wind down of the company's expansion projects will lead to a boost to free cash flow.
Given POT's historical CapEx and free cash flows, I estimate that POT will be able to generate a free cash flow yield of 5-7% over the next several years, enough to support its current dividend yield.
(Source: POT 2012 Annual Report)
Reason No. 4: Replacement Value Is Much Higher
How much do you need to spend to rebuild POT?
A good - actually, nearly perfect - proxy for estimating POT's replacement value is the estimated cost of BHP Billiton's (BHP) Jansen Project, a large potash project in Saskatchewan, where POT is based. The Jansen project is expected to achieve a capacity of 8 million tonnes a year at an estimated cost of $16 billion dollars. Thus, by way of simple mathematics, POT's potash capacity alone is worth approximately $32 billion dollars. Since POT is currently trading at $26 billion, this implies that the whole company is trading at $6 billion less than its potash capacity alone.
Now, remember, in addition to getting a $6 billion discount to the replacement cost of POT's potash capacity, you are also getting - for free - the following assets:
- An extensive, global distribution system,
- Relationships with major clients,
- A nitrogen business that grossed $978 million in 2012,
- A phosphate business that grossed $469 million in 2012,
- Shares of various fertilizer companies that is worth (very) roughly $5 per POT share (see chart below),
- And off-balance sheet goodwill (like The Good Ol' Bill Doyle - for free!)
All I know is that POT is worth significantly more than $30 a share - in the long run.
(Source: POT 2012 Annual Report)
Reason No. 5: Built-In Optionality
The bad news has been priced in. All the analyst reports I've read have priced in lower potash prices driven by Uralkali producing at full capacity. Since this is priced in, you get a free event option with the purchase of a POT share.
Well, maybe not exactly free since things can go from bad to worse. One thing that can go wrong is that the arrest of Uralkali's CEO may retard productive negotiations. However, the news sent potash names up over 2% on this news, so the market does not think arresting Uralkali's CEO is a net negative.
I personally believe that the upside events are much more abundant and likely than the downside events. Here are my thoughts on a few possible outcomes that will drive up potash prices (in some cases, even before prices are driven down):
- Likely: Belarus and Russia will work something out, either forming another cartel with better governance or splitting the market after some intense negotiations.
- Maybe: Uralkali's CEO may get replaced to force a resolution.
- Likely: Uralkali's actual maximum capacity is only 12 million tonnes, not 14 million as stated by the CEO or 13 million as stated in ther investor presentation [pdf]. Maximum production won't impact global potash prices by as much as Uralkali says.
- Likely: Uralkali finds that it is extremely difficult to take market share away from its competitors and that increased volume does not make up for lower price. As a result, Uralkali reverts to the price-over-volume strategy, with or without Belaruskali.
- Highly unlikely, but cool to think about: Armed conflicts result between Russia and Belarus, and we later find out that the problems between the two countries are much bigger than potash (maybe because Putin is bitter about Lukasehnko's fish?).
A Side Note: Uralkali's CEO Is Neither a Smart nor Ethical Man
Uralkali's CEO, Baumgartner, is not as smart as he thinks he is. Let me explain. In a recent interview, Uralkai's CEO made a lot of big (negative) predictions about what will happen in the potash market as if he knows, and people are taking his words for it. However, he can't even predict the outcome of his meeting with the prime minster of a country that is run by a dictator, the same country that he just gave a big middle finger to.
Baumgartner, please repeat after me: "Potash accounts for 12% of Belarus's government revenue. Belarus is run by a dictator, a man who caught a bigger fish than Putin. You just screwed over Belarus. Given the circumstances, you shall not meet with Belarus' prime minster INSIDE Belarus."
Baumgartner, I strongly suspect, is not an ethical man either. I have two reasons for my belief:
- Baumgartner denies that he has knowledge of the two extremely large insiders' trades that occurred prior to the announcement that he is breaking up the BPC cartel, an announcement that sent shares of publicly traded potash companies crashing. It would take more than a giant leap of faith to believe him.
- The abrupt way that Baumgartner announced the decision to break up the BPC cartel and the dire picture that he painted of the outcome of this action is not at all a responsible way to handle the situation - I simply cannot think of a worse way. His actions are a huge insult to all the small investors who are kept in the dark.
This article has put together many pieces of data and speculation. There are many moving pieces to be sure and the conclusion cannot be easily summarized (this entire article is a summary). However, taken together, I do believe that POT has a good risk-reward profile.
Please share your thoughts and let me know if you are interested in any related, follow-up articles. I would love to hear from you. Please leave your comments below or contact me through my website. Thanks for reading!